EconSouth (First Quarter 2007)

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Volume 9, Number 1
First Quarter 2007


After the Boom, Housing Affordability a Growing Challenge

Florida Drives the National Auto Market

A Falling Dollar: Good or Bad News?


Fed @ Issue


State of the States

Q & A

Research Notes & News

Southeastern Economic Indicators



A Falling Dollar: Good or Bad News?

In recent years, the U.S. dollar has fallen in value against some other major currencies around the world. Whether this decline helps or harms the U.S. economy is a matter of perspective.

currency cartoon graphic
Illustration by Odie Swanegan

Some of the effects of a weaker U.S. dollar are readily apparent to American consumers. Imported goods and services are more costly. Vacationing in Europe is more expensive. The prices of Chinese-made home appliances, German cars, and other imported goods are up.

For those outside the United States, a weaker dollar means their investments in the United States lose value, because their assets are worth less when measured in their home currency.

Nonetheless, in the eyes of many economists, the U.S. dollar's depreciation, or its loss of value against another currency or group of currencies, is actually a positive development. These economists believe that the more the dollar depreciates, the more it helps to alleviate one of the biggest imbalances in the U.S. economy: the current account deficit.

The dollar's role in the current account balance
The current account balance is the net value of a country's international trade in goods and services plus the net value of income payments and transfers to and from foreigners. As it is in most developed economies, the U.S. current account balance is led primarily by the performance of the trade balance, especially the difference between imported and exported goods. For the United States, the driving force behind the current account imbalance has been the growing trade deficit that the United States has been running for more than a decade.

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Fed Vice Chair Ferguson on the current account

Correcting U.S. external imbalances
Many analysts think that a weaker dollar could help narrow the U.S. current account imbalance by making U.S. exports cheaper and thus more attractive to foreign buyers while making imports less attractive to Americans. This scenario is sometimes considered a natural correction mechanism among open economies. At least two examples in recent U.S. history provide evidence of this kind of adjustment.

The first correction occurred during the early 1970s, and the second episode took place in the late 1980s (see chart 1). Both times, the depreciating real exchange rate helped generate a large positive adjustment in the balance of payments. Many economists today expect a similar development to occur and are looking for signs that indicate that the depreciation of the U.S. dollar is helping to correct the economy's external imbalances.

Closer examination of the data reveals that the dollar actually has been trending lower for more than five years after reaching a peak during the first quarter of 2002. JPMorgan's trade-weighted real exchange rate index has declined by about 22 percent from February 2002 through the end of 2006 (see chart 1). Other measures display a similar decline. For instance, the Federal Reserve Board's real exchange rate index, which uses a slightly different basket of countries and weights, has declined by about 15 percent.

Chart 1
Real Exchange Rate and the Current Account Balance
Source: JPMorgan (real exchange rate),
Bureau of Economic Analysis (current account balance)

Against specific currencies such as those of some major U.S. trading partners, the depreciation rates are even higher. The dollar was down about 50 percent against the euro, 39 percent against the Canadian dollar, and 37 percent against the British pound from 2002 to 2006 (see chart 2).

The trade imbalance and the consequent U.S. current account deficit continue to outpace growth in the gross domestic product (GDP), a development that has perplexed economists. Are the natural correction mechanisms that worked in the past not responding as experience has shown they would?

Assessing the corrective factors
A few explanations exist to explain why the U.S. dollar's depreciation has not translated into a change in the direction of the trade balance. The evolution of U.S. private and public consumption, the country's monetary policy, and the capacity of importers to pass on cost increases to American consumers all play roles in this situation.

Consumption. With GDP growth fueled by private consumption, the U.S. economy has been expanding at a brisk pace since the 2001 recession. Strong private and public consumption in the United States has kept demand high for both foreign and domestic goods. In addition, a growing economy also naturally tends to demand greater quantities of imports related to productive activities, such as fuel and industrial supplies, which allow production to continue and maintain the rate of expansion.

Monetary policy. While the general trend of the U.S. dollar's exchange rate has certainly been downward, we have seen some upward movement during 2002–06, spurred by changes in U.S. monetary policy.

Between June 2004 and June 2006, the Federal Reserve steadily increased the federal funds target rates, raising demand for the dollar at a time when interest rates in Japan were virtually zero and were at 2 percent in Europe. Since holding dollars gave a higher yield than some other major currencies offered, dollars remained attractive to investors. In part as a result, the U.S. dollar appreciated on average 3.6 percent during 2005 (see chart 3).

This tightening of U.S. monetary conditions and the low interest rates in other developed economies helped delay the depreciation of the U.S. dollar and allowed American consumers to buy cheaper imported goods for a little longer.

Imports. Much has changed in the world since the early 1970s and mid-1980s. Specifically, the world has become highly interconnected, especially through trade, and global competition has worked to lower the prices of goods and assets. While U.S. importers have had difficulties passing on increases in their costs related to exchange rate fluctuations, such increases have become even harder in recent years. So once again, even in the face of a falling dollar, American consumers are able to continue buying foreign goods at relatively low prices.

Chart 2
Selected Foreign Currencies Relative to the U.S. Dollar
Source: Haver Analytics

How far and how fast?
According to recent data from the U.S. Department of Commerce, the United States' current account deficit was about $857 billion in 2006, slightly more than 6.5 percent of the country's GDP that year. Many economists believe that it would be difficult for the United States to prolong this situation indefinitely and that the dollar's depreciation provides a mechanism for adjusting the trade balance. The difficult question, though, is what speed and extent of depreciation are desirable.

Currently, most analysts expect a smooth and gradual depreciation of the U.S. dollar. Underlying their forecasts is the belief that those factors that were depressing natural correction mechanisms in the past are either less strong or no longer present. With interest rate differentials among currencies at a minimum, monetary policy is not expected to provide further support for the U.S. dollar.

Chart 3
U.S. Dollar's Real Trade-Weighted Foreign Exchange Rate
Source: Federal Reserve Board of Governors

In addition, with the economy's growth having slowed somewhat, many analysts belive that additional demand for imports should slow correspondingly because imports into the United States tend to be more directly responsive to GDP growth (and accompanying demand growth) than to changes in the exchange rate.

For these reasons, analysts believe that part of the adjustment to the dollar's value likely will come as a result of a depreciated dollar, which makes exports more attractive to foreigners while making imports more expensive for domestic consumers. Another part of the correction likely will be made indirectly through changes to consumption and income growth, as slower GDP growth typically provides consumers with fewer resources to spend on less affordable imports. Some analysts believe this development is under way already, as U.S. export growth outpaced import growth during the last quarter of 2006. But one quarter does not constitute a trend.

Stability abets future correctives
While no consensus exists about the timing or speed of the adjustment to the value of the dollar, the natural correction mechanisms appear to be in place. As long as the current situation of strong global growth and impressive macroeconomic stability continues, the United States should be able to correct its external deficits smoothly, without enduring significant hardships.

This article was written by Diego Vilán, an economist in the regional section of Atlanta Fed's research department.